Economic View: Brown treads a tax tightrope

Michael Howard's appointment last week of company doctor David James to seek out Whitehall waste was the opening shot in what promises to be a ferocious political battle over tax and spending this year.

With Gordon Brown due to announce spending totals for the next three to four years in his spring Budget, we will soon know the lines of attack the main parties intend to use as the next election approaches.

Neither faces an easy task. The Chancellor has conceded that even if he stops increasing current government spending as a share of national income, the share taken in tax is going to have to rise for years to come. And if the Tories want to slow or halt this rise in the tax burden without abandoning Mr Brown's fiscal rules, they are going to need big savings from his spending plans. Easier said than done, even for the good doctor.

The battle takes place against an unpromising background. The Treasury's public finance forecasts have now proved over-optimistic three years running. Depressed tax revenues mean the Government expects to have to borrow £37bn this year - 3.4 per cent of national income. In part this reflects the fact that the Treasury believes economic activity is running 1.4 per cent below the sustainable level consistent with stable inflation. If the economy were running at full potential - boosting tax revenues and reducing welfare bills - the deficit would be nearer £26bn.

But this is still the largest underlying deficit since Labour came to power. And it would look bigger still if the International Monetary Fund is right that there is less spare capacity in the economy than the Treasury thinks.

Of course, this does not mean that there is a crisis in the public finances - government debt is modest by historic and international standards. But Mr Brown also wants to be judged by his famous fiscal rules. The "golden rule" allows the Government to borrow only for investment. Other spending has to be covered by tax and other revenues - not every year, but on average over the economic cycle.

When the Chancellor talks about the golden rule, he focuses on what he regards as the present economic cycle - from 1999-2000 to 2005-06. Mr Brown said last month that during this period he expected the golden rule to be over-achieved by £14bn.

But with two-and-a-half years of the cycle to run, and an average forecasting error in the budget deficit just a year ahead of £11bn, this is cutting things fine. If Treasury forecasts prove over-optimistic again, meeting the golden rule between these dates could demand some pretty strange policy decisions as the finishing line approaches. Better to focus on what needs to be done to meet the golden rule on average in the future.

In the Pre-Budget Report, the Chancellor assumed that the steady rise in current spending from 37 to almost 40 per cent of national income seen over the last four years will come to a halt this year and that the share will remain roughly constant at least until 2008-09. There is little indication that he will opt for anything very different when we get to the Budget.

This would stabilise current spending at roughly the level Labour inherited from the Conservatives in 1997 (although the Government would argue that it is being spent more sensibly). This underlines the pressure it faces to deliver noticeable improvements in public services without the benefit of further increases in the overall spending share.

With revenues falling sharply between 2000-01 and last year, the rise in expenditure has been financed by increased borrowing. But to ensure Mr Brown remains on course to meet the golden rule with the comfort he has sought in the past, the increase in spending we have already seen will need to be matched by an increase in tax revenues almost as large.

To be more specific, the Treasury itself projects that it will take around 2.6 percent of national income more in tax in 2008-09 than last year - equivalent to an increase of almost £30bn in today's prices. This will lift taxes above 38 per cent of national income and total current receipts above 40 per cent for the first time since the mid- to late 1980s.

Where does Mr Brown expect all this extra revenue to come from? After all, he has not announced any big increases in tax rates.

Well, partly from a rise in economic activity getting back to its full potential, which will increase the share of national income taken in tax. Partly from a rise in corporation tax receipts, as a stronger stock market boosts City profits. Partly from a rebalancing of economic activity towards more highly taxed areas, such as consumer spending. And partly from a rise in the number of higher-rate taxpayers, as allowances and thresholds (both of which are assumed to be uprated with inflation) fall relative to average earnings.

Whether these factors will bring in quite as much revenue as the Government hopes is debatable, and the Institute of Fiscal Studies will assess this in its Green Budget later this month. If not, the Chancellor may need to announce fresh measures to bring about the rise in the tax burden he thinks necessary.

But whether the Government has to announce new measures or not, one way or another, the Treasury believes that the proportion of national income it takes from our pockets should increase significantly. In that sense, the question is not whether taxes will rise, but how.

Robert Chote is the director of the Institute of Fiscal Studies